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Selling Partnerships That Own CFCs: A Potential Trap for the Unwary

In addition to many other tax
benefits, partnerships offer flowthrough treatment for the
partners, which generally results in only one layer of tax
and a high level of tax efficiency. In the international
tax context, partnership structures are widely used,
particularly as collective investment vehicles such as
private-equity funds, hedge funds, mutual funds, etc.
Businesses such as manufacturers and service providers
also commonly use partnerships. As businesses seek to
avoid corporate taxes, the use of partnerships (and other
flowthrough vehicles) has increased.

Partnerships
carry a number of traps for the unwary, as the interaction
between the technical partnership rules and myriad complex
international tax rules is often unclear. Many issues
arise because of uncertainty over which theoretical
approach to partnership taxation—either the aggregate or
entity approach—applies. Under the aggregate theory, a
partnership is viewed as an aggregation of its partners,
and the partnership is treated as a conduit. In addition,
the partners are treated as directly engaged in the
partnership's activities. Conversely, under the entity
theory, the partnership is treated as an entity separate
from its partners, and each partner merely owns an
interest in the partnership and is not treated as
conducting the activities of the partnership.

The
authorities underlying whether to apply the aggregate or
entity theory to particular areas of partnership taxation
are extensive and outside the scope of this item, but the
rules governing which approach to take with respect to a
particular provision of the Code generally are based on
which theory more appropriately achieves that particular
Code section's policy goals.

This item highlights
a potential trap in the context of a fairly simple fact
pattern—the sale of an interest in a partnership (U.S. or
foreign) where the partnership owns stock of a controlled
foreign corporation (CFC). Specifically, it addresses
whether gain recognized on a sale of a partnership that
owns CFC stock should be treated as capital gain or
ordinary income.

Sale of Partnership
Interests: In General

Under Sec. 741, the sale of
a partnership interest is treated as the sale of a capital
asset. As such, the partner recognizes a capital gain or
loss, depending on the amount realized from the sale and
the partner's outside basis in the partnership interest.
Thus, Sec. 741 represents an application of the entity
theory, with the partner treated as selling an interest in
a separate entity. An exception to this general rule is
contained in Sec. 751.

Sec. 751(a) generally
provides that any amount received by a partner in exchange
for all or a part of the partner's interest in the
underlying unrealized receivables or inventory items of
the partnership is considered an amount realized from the
sale or exchange of property other
than a capital asset. Congress enacted Sec. 751 in
1954 to prevent the conversion of potential ordinary
income into capital gain upon the transfer of a
partnership interest. The statute accomplishes this by
applying an aggregate approach, by which the partner is
treated as directly selling the ordinary-income-producing
property.

Under Sec. 751(c), the term
"unrealized receivable" includes stock in a CFC,
but only
to the extent of the amount that would be treated
as gain to which Sec. 1248(a) would apply.

Sec. 1248: In General

In general, if
a U.S. shareholder that owns 10% or more of the voting
stock of a CFC sells stock in that CFC, Sec. 1248
recharacterizes the gain on such a sale as a dividend, to
the extent of the undistributed earnings and profits
(E&P) attributable to the stock sold (the Sec. 1248
amount). If the selling U.S. shareholder is a C
corporation, gain treated as a dividend under Sec. 1248 is
generally eligible for foreign tax credit relief under
Sec. 902. Corporations do not receive preferential tax
rates on dividends from foreign corporations or capital
gains recognized on the sale of stock. Therefore, the
application of Sec. 1248 generally produces a benefit to
corporations.

If the selling U.S. shareholder is a
noncorporate taxpayer (e.g., an individual), the deemed
dividend may be treated as a qualified dividend eligible
for reduced rates under Sec. 1(h)(11). For a U.S.
shareholder to claim a reduced rate, the CFC must be a
"qualifying corporation." Specifically, the CFC
must be eligible for the benefits of a tax treaty listed
in Notice 2011-64. Qualified dividend income is eligible
for a reduced rate for noncorporate taxpayers (currently,
a maximum rate of 20%, the same rate applicable to capital
gains). However, since individuals and other noncorporate
taxpayers do not receive indirect foreign tax credits
under Sec. 902 on dividends from foreign corporations
(although they may claim direct foreign tax credits on any
taxes paid on foreign dividends), the application of Sec.
1248 is generally tax-neutral in this context (assuming
the CFC is in a tax treaty jurisdiction).

However,
Sec. 1248 does not apply in all circumstances. Sec.
1248(g) lists specific exceptions where the application of
Sec. 1248 is precluded and gain on the sale of CFC's stock
is not
recharacterized as a dividend. Under Sec. 1248(g)(2)(B),
Sec. 1248 does not apply to "any amount to the extent
that such amount is, under any other provision of this
title, treated as . . . ordinary income."

Treasury's Position

Neither Treasury
nor the IRS has issued formal guidance on the application
of Secs. 751(c) and 1248(g)(2)(B) to sales of partnership
interests, and no court has ruled on the interaction of
these provisions. However, language in the preamble to the
Sec. 1248 regulations suggests that Sec. 1248 does not
apply to sales of partnership interests. InT.D. 9345,
Treasury commented that language in Regs. Sec.
1.1248-1(a)(4) relating to the treatment of sales of CFC
stock by non-U.S. partnerships was not intended to apply
to the sale by a partner of its interest in a non-U.S.
partnership holding stock of a CFC because it would be
contrary to Sec. 1248(g)(2)(B).

Additionally, in
T.D. 9644, Treasury stated that

[t]he Treasury Department and
the IRS believe that the section 1411 characterization of
the section 751(c) amount that corresponds to a section
1248 dividend should be consistent with the chapter 1
characterization and not treated as a dividend, and thus
do not adopt the recommendation to treat the amount as net
investment income under section 1411(c)(1)(A)(i) or add an
example to the final regulation.

Based on this
language, it appears the government believes that the sale
of an interest in a partnership that owns a CFC should be
treated as the sale of a noncapital asset (to the extent
of the untaxed E&P as computed under Sec. 1248) and
produce ordinary income under Sec. 751(c). This ordinary
income inclusion would
not be eligible for dividend treatment under Sec.
1248 due to the application of Sec. 1248(g)(2)(B).
Qualified dividend rates would therefore not apply. If
Sec. 1248 does not apply to a sale of a partnership
interest, a corporate seller of an interest in a
partnership that owned a CFC could not use Sec. 1248 to
characterize the Sec. 751(c) income as a dividend and
receive the benefit of indirect foreign tax credits.
Noncorporate taxpayers would be taxable at ordinary income
rates.

Treasury's position appears to rely on a
technical reading, which could be construed as
inconsistent with the congressional intent and tax policy
underlying Sec. 751 because an indirect sale of a CFC
through a partnership produces a worse result than a
direct sale. This result appears to be a technical glitch
that has resulted from the enactment of preferential rates
for dividends subsequent to the enactment of Sec. 751.

If a partner were to sell a CFC interest directly,
Sec. 1248 would clearly apply. Gain would be
recharacterized as a dividend to the extent of the Sec.
1248 amount and potentially be eligible for a reduced tax
rate under Sec. 1(h)(11). Similarly, if a partnership sold
the CFC, the Sec. 1248 amount would be recharacterized at
the partnership level and flow through to the partners.

Under the Treasury approach, the interposition of a
partnership would convert income otherwise eligible for
preferential dividend treatment into nonpreferential
ordinary income. The approach would therefore produce
results different from what might result under an
aggregate approach. This seems contrary to the original
intent of Sec. 751, which generally applies an aggregate
approach to sales of partnership interests.

If the
CFC is in a tax treaty jurisdiction (and is eligible for
treaty benefits) or the selling shareholder is a corporate
taxpayer, the Treasury position arguably reaches the wrong
result because gain on the sale of a partnership that
directly owns the CFC would result in ordinary income
rather than qualified dividend treatment. If the selling
partner is a noncorporate taxpayer and the CFC is located
in a nontreaty territory, then the interaction between
Sec. 751(c) and Sec. 1248(g)(2)(B) appears to reach the
correct result, albeit through different means. In this
case, it would turn an amount that would otherwise be
eligible for a reduced rate as a capital gain into an
amount taxed at ordinary income rates, thus achieving the
same result as if the partner had sold it directly.

Arguably, the correct policy approach would be to have
Sec. 1248 apply to the Sec. 751(c) amount and to tax this
amount under other relevant Code sections (e.g., Sec.
1(h)(11)). This would reflect an aggregate approach
consistent with the policy underlying Sec. 751.

Are There Alternatives?

Depending on
the facts, avenues may exist to ensure Sec. 1248 treatment
and avoid an adverse result under the Treasury approach.
Obviously, a direct sale of the CFC by the partnership
would be taxed under Sec. 1248. In addition, a synthetic
asset sale (e.g., contributing the CFC stock to a
disregarded entity and selling the disregarded entity)
could also result in dividend treatment under Sec. 1248.
This dividend would flow through to the partners and be
taxed accordingly, based on each partner's corporate or
noncorporate taxpayer status.

Another alternative
would be to "check the box" immediately prior to
sale to treat the CFC as a disregarded entity (a so-called
check-and-sell transaction), which would result in a
deemed liquidation of the CFC followed by a distribution
of the CFC's assets to the partnership for U.S. tax
purposes. While taxpayers typically use this strategy to
avoid subpart F income on the sale of CFC stock, the
deemed liquidation of the CFC would likely be taxed under
Sec. 1248 and not Sec. 751 because gain recognized on a
liquidation is generally taxable under Sec. 1248. Any gain
subsequently recognized by the selling partner on a sale
of the partnership interest would be taxable under Sec.
751, but only to the extent of any unrealized receivables
in the asset base of the former CFC.

Another
possible approach would be to contribute the stock of the
CFC to a U.S. corporation prior to the partner's exiting
the partnership. This could avoid the application of Sec.
751 because stock in a U.S. corporation is not subject to
Sec. 751.

Clearly, some of these approaches depend
on all partners of the partnership agreeing to the same
holding and exit strategies and timing with regard to the
investment in the CFC. If all partners exit the
partnership at the same time, these approaches may be
viable. However, if the exiting partner is a minority
owner, the other partners may be unwilling to modify their
investments to facilitate an exiting member, particularly
if the suggested approach would cause all of
the partners to realize income (e.g., if the
partnership sells a CFC directly or makes a check-the-box
election).

Finally, a taxpayer may be able to take a
position contrary to the government's position based on
policy grounds. For example, an individual taxpayer could
take the position that Sec. 751 should not apply in lieu
of Sec. 1248 because the mechanical operation of Secs.
751(c) and 1248(g)(2)(B) results in a worse outcome
compared with the partner's selling the assets directly—a
consequence inconsistent with the general legislative
intent underlying Sec. 751. Given the lack of direct
guidance to the contrary, this may be a viable position,
but it should be fully vetted, and taxpayers should
carefully consider whether this position can be taken,
consistent with current return preparer standards and the
potential need to disclose the position to the IRS.

Conclusion

The uncertainty
surrounding the interaction of Secs. 751(c) and
1248(g)(2)(B), along with Treasury's comments on the
matter, should lead taxpayers and their advisers to tread
carefully when planning a partner's exit from a
partnership. At the very least, a calculation should be
performed to identify the potential exposure arising if
qualified dividend treatment is not available and
determine whether the risk is material. If possible,
alternative transaction structures should be considered to
mitigate this potential risk, but this may not always be
possible.

EditorNotes

Mindy Tyson Weber is a senior director, Washington
National Tax for McGladrey LLP.

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